Puerto Rico: The New Detroit

Puerto Rico may have miscalculated when it enacted legislation recently to allow the restructuring of some $20 billion of debt issued by various public corporations, notably the Puerto Rico Electric Power Authority (Prepa), Puerto Rico Highways and Transportation Authority (Prhta), and the Puerto Rico Aqueduct & Sewer Authority (Prasa).

The goal was to cut loose those financially ailing entities from direct government support and thus preserve needed liquidity for the central government. That in turn was supposed to bolster both Puerto Rico's general-obligation bonds and Cofina, an issuer of about $15 billion of debt backed by sales-tax receipts that has been long viewed as the top credit on the island.

However, Puerto Rico's action has backfired with investors who reason that if the commonwealth is willing to change laws to undermine one group of bondholders, it may be just a matter of time before the economically depressed island seeks to restructure other debt.

As we warned last year, Puerto Rico is moving to restructure some debt, slamming municipal-bond investors as well as bond insurers.

In a major move that surprised the markets, Moody's Investors Service on Tuesday sharply reduced credit ratings on all major Puerto Rico debt issues, which now have across-the-board junk ratings. "By providing for defaults by certain issuers that the central government has long supported, Puerto Rico's new law marks the end of the commonwealth's long history of taking actions needed to support its debt," Moody's wrote. The GOs were dropped to B2 from Ba2, and Cofina's senior debt was cut to Ba3 from Baa1; the latter is an investment-grade rating.

The benchmark 8% Puerto Rico bond due in 2035 fell about 5%, to 85 cents on the dollar, and now yields 9.81%. That $3.5 billion deal was sold with much fanfare in March at a price of about 93. Prepa's long-term debt, which was already depressed in anticipation of a potential default, fell to 40 cents on the dollar from 45 cents. Cofina debt was hard hit, with a 6% issue due in 2041 dropped to 67 cents on the dollar from 82 cents and its yield lifted to 9.4%.

Less than a year ago, Barron's warned in a cover story that Puerto Rico was in danger because of "weak economy, persistent budget deficits, and onerous debt" ("Troubling Winds," Aug. 26, 2013). Our view was that a Puerto Rico debt restructuring was a distinct possibility, despite an insistence to the contrary by the government. Puerto Rico would likely impose only so much financial pain on its relatively poor residents, we reasoned, to benefit the affluent group of mainlanders who own its debt.

The bull case now is that Puerto Rico is committed to protecting the GO debt and Cofina, and that yields, which are tax free on most bonds, are enough to compensate for the risk. A former deadbeat country like Ecuador has issued debt at 7%, and Argentine bonds yield 9%.

But Puerto Rico bond yields still may not be enough to compensate for the risks. The likely restructuring proposal that Puerto Rico is expected to put forth for Prepa and the other government corporations could be punitive. And the new law gives bondholders few rights and essentially strips them of their lien on essential-service revenues. Investors are also unhappy that Puerto Rico is treating its own loans to those public corporations through the Government Development Bank, a commonwealth financing arm, as untouchable.

Puerto Rico has burned its two largest mutual-fund investors, OppenheimerRochester and Franklin, which are suing the commonwealth, arguing the new law is unconstitutional. "The government is effectively saying it is no longer willing to pay back loans used to build Puerto Rico's essential transportation, power, and water and sewer infrastructure, in full or on time," wrote analysts at Nuveen Asset Management last week. "Barring a significant and lasting revival in Puerto Rico's economic trajectory, we believe the commonwealth will continue to struggle with budget deficits and may ultimately enact similar restructuring measures for its general-obligation debt."

The Puerto Rico mess does appear to demonstrate the value of muni-bond insurance because insured debt was trading at far better levels than uninsured bonds. The share price of two leading insurers,
Assured Guaranty
(ticker: AGO) and
MBIA
(MBI), did decline last week, but the companies should be able to weather any Puerto Rico defaults. Assured Guaranty fell 6%, to $23.20, and MBIA was down 10% to $10.29. Investors are worried that the two companies might be forced to raise capital to offset any Puerto Rican losses.

Assured Guaranty has $5.3 billion of exposure to Puerto Rico, including $2.4 billion to the three main corporations likely targeted for debt restructuring, according to its March 10-Q report. MBIA has $4.8 billion of Puerto Rico exposure, including about $2.5 billion to the three corporations.

-- Andrew Bary

MercadoLibre's eBay Problem

The idea for the e-commerce company
MercadoLibre
came to Marcos Galperin when he was at Stanford's business school in the 1990s: Clone eBay in Latin America. He succeeded admirably, growing the company's revenues to $473 million in 2013, with net earnings of $118 million, or $2.66 a share. While the Nasdaq-listed shares (ticker: MELI) have settled back from last year's $146 peak to a recent $96, they still go for 32 times estimates for next year's earnings—a multiple that doesn't discount some new worries for the eBay of Latin America. One of those worries is eBay itself.

MercadoLibre's biggest shareholder is, in fact,
eBay
(EBAY), with an 18% stake acquired when Galperin's firm took over eBay's Brazilian operation in 2001. One bullish thesis, therefore, was that eBay would buy the rest of MercadoLibre someday. Instead, eBay is expanding its own business in competition. Last September, eBay launched a Portuguese app for fashion shoppers in Brazil, where MercadoLibre gets half of its revenue. The U.S. giant said the venture was just the start of its Latin American ambitions for the eBay online marketplaces and PayPal payment service. Our 2012 story about MercadoLibre prematurely cried wolf about Latin American competition from
Amazon.com
(AMZN), when the shares were at $75 ("With Amazon in Hot Pursuit…" May 28, 2012), but perhaps the e-commerce giants are finally going to make a serious run at MercadoLibre's turf.

We were closer to the mark a year ago when we warned that MercadoLibre's shares, then $112, were riding revenues inflated by the use of Venezuela's unrealistic official exchange rate to compute the company's U.S. dollar-denominated results ("MercadoLibre's Venezuela Problem," July 15, 2013). In May, MercadoLibre announced it would remeasure its results using Venezuela's recently unveiled exchange system, where a U.S. dollar gets about 50 Venezuelan bolivars. That compares with the VEB10-per-dollar that MercadoLibre had used back in March, and the six per dollar it used when we wrote our story. We noted that other companies reported Venezuelan revenues at a fourth the dollar exchange rate that the little e-commerce outfit was using.

Under MercadoLibre's newly realistic currency reporting, the company warned that its June 2014 results will include a write-down of bolivar-denominated assets that could exceed $50 million, and foreign-exchange losses of perhaps $20 million, but a tax benefit of as much as $9 million. Because the quarter's revenues won't be inflated by a fanciful exchange rate, MercadoLibre also suggested that analysts trim their sales forecasts by $15 million.

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